4 Risks To Avoid When Using Leverage in Real Estate

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When appropriately used, real estate leverage can be an effective tool for real estate investors to increase their return on investment. The key is to avoid making decisions without proper consideration of the areas of risk in leverage. Avoid these high-risk behaviors and you have a far better chance of realizing success in using real estate leverage.

Key Takeaways

  • Leverage can be a great tool for real estate investors, but it comes with several risks to watch out for.
  • High levels of appreciation are not a guarantee, as past performance isn't an airtight predictor of the future.
  • The drawback of the low down payment investors often look for in an investment property is that payments could become too high.
  • Getting good financing may lead investors to buy bad properties.

Counting on High Levels of Appreciation

Real estate investors can get into trouble by thinking that what happened before in the real estate market is going to happen again. History, however, is no predictor of the future. You can't rely on the future to produce the same results.

Even if the property has been appreciating at a 12% to 20% rate for several years, counting on that rate to continue is an extremely risky proposition. It can cause you to overpay for properties, expecting to realize the difference at the sale from appreciation. If it doesn't happen, you're holding a loss.

When you plan out your leveraged real estate investments, look at three scenarios: best, worst, and most likely.

Ending Up With Too High a Payment

It can seem like a great investment to control property with a very low down payment. You're looking at the numbers and seeing a really high return on investment due to your low cash outlay.

The problem? Higher payments come with higher leverage. If this is a mortgage, for instance, you can count on having to make monthly payments, and the more you borrow, the higher the monthly payment.

Should the market soften or your properties experience higher-than-expected vacancies or credit losses, you could find yourself unable to maintain those higher mortgage payments that seemed fine at the beginning. If that happens, your investment is in jeopardy.

Letting Good Financing Result in a Bad Purchase

Many an investor has overpaid for a property because they found a unicorn high-leverage financing setup. Said differently, just because you can get a property with very little cash outlay doesn't mean that it's a good buy. Look at the value of the property in the context of current and expected market trends. Find comparables. What have they sold for? What is selling in the area?

If the property is overpriced, appreciation will be minimal or, worse, non-existent. If the market retraces itself for a while, you're in serious trouble. Your overpriced property will be a significant drag, and you won't be able to unload it without taking a loss.

Forgetting That Cash Flow Is King

If just one of these "don't" behaviors sticks in your mind, this is the one. Errors in judgment in one or more of the other items here can be overlooked if you have that one great thing—excellent cash flow.

If your rental income minus your mortgage costs and expenses is putting a nice cash return in your pocket every month, then the fact that the property didn't gain in value this year won't be as worrisome of an event. But if all your real estate investments are down, your low cash flow could cause serious problems.

Frequently Asked Questions (FAQs)

What is leverage in real estate?

Leverage in real estate is using debt to increase the potential return on investment. The most straightforward example for real estate is a mortgage, where you're using your own money to leverage the purchase. In most cases, a 20% down payment (and a good credit history) gets you the property and house you want. A 20% down payment means you're using 80% leverage, and some mortgage programs may even let you put down less.

What are the main risks of using leverage in real estate?

While leverage is an important part of real estate investment, there are significant risks, such as a property not appreciating, ending with too high a monthly payment, forgetting about the importance of cash flow, and letting good financing convince you to make a bad purchase.

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  1. Center Street Lending. "The Risks and rewards of Using Leverage in Your Investment Financing."

  2. Aviara Real Estate. "The Danger of Over-Leveraging in Real Estate Investments."

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